Cash or Accrual?

Choosing or changing a method for tax purposes.

THE IRS RELEASED REVENUE PROCEDURE
2000-22 and revenue procedure 2001-10 to
give small businesses some much needed guidance on
choosing or changing their accounting method for tax
purposes.

REVENUE PROCEDURE 2000-22 ALLOWS
ANY COMPANY —sole proprietorship,
partnership, S or C corporation—that meets the
sales test to use the cash method of accounting
for tax purposes. If a company’s average revenue
for the last three years is less than $1 million,
the cash method is allowed but not required.

COMPANIES THAT FAIL THE $1 MILLION
AVERAGE revenue test are not affected
by the revenue procedure. For them, determining
whether to use the cash or accrual method hinges
on two issues: the material income-producing
factor test and their type of entity.

COMPANIES SELLING MERCHANDISE
GENERALLY must use the accrual method
to account for purchases and sales. In a 2000
case, the courts held that the material
income-producing factor test does not apply when
the material is inseparable from the services and
the sale or use of the material is subordinate to
providing services.

C CORPORATIONS (OTHER THAN FARMS)
MUST USE the accrual method if their
average annual gross receipts for the previous
three years were more than $5 million. Tax
shelters and general partnerships that have C
corporations as partners and fail the $5 million
test also must use the accrual method.

ROBERT JENNINGS,
CPA, is president of Jennings Advisory Group, LLC,
in Clarksville, Indiana. He is also adjunct lecturer
in taxation in the equine industry program at the
University of Louisville in Kentucky. His e-mail
address is taxspeaker@aol.com
.

ith the release of revenue procedure 2000-22,
the IRS provided small businesses with much needed guidance
on choosing or changing their accounting methods for tax
purposes. This article summarizes the rules that apply when
businesses must pick an accounting method and examines some
of the other factors that influence their decision.

Revenue procedure
2000-22 allows any company that meets a sales test to use
the cash method of accounting for tax purposes. This
includes sole proprietors, partnerships, S corporations and
regular corporations. If a taxpayer meets the sales test, it
no longer matters whether it is selling merchandise that is
a “material income-producing factor” (discussed below).

To compute the sales test, a company averages revenue
from the last three years. If the average is less than the
$1 million threshold, the cash method is always allowed (but
not required). For purposes of this test gross receipts
include most normal items, such as sales revenue, services,
interest, dividends, rents, royalties and the like, but not
sales tax the taxpayer collects.

Companies that are
part of controlled groups must combine receipts for all
entities included in the group to determine if they meet the
$1 million test. Short years require an annualization
adjustment. For taxpayers in business less than three years,
the average is computed using revenue from only the years in
existence.

The revenue procedure originally had
included one other requirement: the conformity rule. Except
in isolated circumstances, such as on a one-time basis to
obtain a bank loan, the taxpayer was required to use the
cash method of accounting for financial statements prepared
for any party—management, investors or creditors—and for any
year ending after December 16, 2000. This requirement would
have undoubtedly caused problems when an accountant prepared
accrual-basis financial statements for a small business
client. The IRS remedied the problem early this year in
revenue procedure 2001-10, which removed the conformity
requirement but reemphasized the need for adequate books and
records—as required by IRC section 446—and reminded
companies to maintain a reconciliation between book and tax
income.

PASS/FAIL

Revenue procedure 2000-22 does not apply to companies
that fail the $1 million average revenue test. For these
entities, determining whether to use the cash or the accrual
method is based on two issues: the material income-producing
factor test and the type of entity. Generally companies that
sell merchandise must use the accrual method for purchases
and sales. This rule is more properly known, under Treasury
regulations section 1.446-1, as the material
income-producing factor rule.

In the past, the IRS
used this rule to force taxpayers to change to the accrual
method, arguing the cash method did not clearly reflect
income. In early 2000, the IRS lost a key court case (
Osteopathic Medical Oncology and Hematology, 113
TC No. 16). The courts held that the material
income-producing factor test would not apply when

Material was inseparable from the services.

Sale or use of the material was subordinate to
providing the services.

Although the IRS acquiesced
in result only, this case forms the basis for arguments that
entities such as medical specialists, architects or
contractors may present to support their use of the cash
method in similar situations when they have more than $1
million in annual sales.

Additional court cases and
informal IRS statements seem to indicate that, when the cost
of purchases is 8% or less of total receipts, the cash
method would be allowed in certain entities. For purposes of
this article, an entity that meets either the requirements
in Osteopathic Medical or the 8% test will be
called a service business and will be considered to meet the
requirements to use the cash method, except as discussed
below.

The second issue companies must consider is
their type of entity. C corporations (other than farms) must
use the accrual method if they have average annual gross
receipts for the previous three tax years of more than $5
million [IRC section 448(b)(3)]. The accrual method is also
required for tax shelters [IRC section 448(a)(3)], and for
general partnerships failing the $5 million test that have a
C corporation as a partner (section 448(a)(2)).

THE RUNDOWN

Other than for farmers and the unusual tax shelter and
corporate partner exceptions discussed above, the rules in
revenue procedure 2000-22 can be summarized as follows:

The cash method is always allowed if the entity
meets the $1 million average revenue test.

The entity test does not apply.

The cash method is allowed if the company has
more than $1 million in sales and meets the service business
test.

The accrual method is required if the entity
fails both the $1 million average revenue and the material
income-producing factor tests.

For C corporations:

The cash method is allowed if the company is a
qualified personal service corporation.

The cash method is always allowed if the
corporation meets the $1 million average revenue test.

The cash method is allowed if average sales are
over $1 million but less than $5 million and the company
meets the service business test.

The accrual method is required if the entity
fails both the $1 million and the material income-producing
factor tests.

The accrual method is required if the company
has more than $5 million in average sales.

The
exhibit below includes a flow chart to help small businesses
select the proper accounting method.

A GOOD BEGINNING

Revenue procedure
2000-22 and the subsequent revenue procedure 2001-10 will
not solve the cash or accrual questions that have plagued
CPAs for the last 25 years. They are, however, a needed
first effort at easing the recordkeeping and compliance
burdens of small businesses. Small business groups, as well
as many members of Congress, continue to push for a further
relaxation of the sales test so that it will affect only
companies with sales between $2.5 million and $5 million
annually. With the election of a Republican administration
bent on tax changes, the likelihood of future increases in
the sales threshold seems greater.

The results of the 2016 presidential election are likely to have a big impact on federal tax policy in the coming years. Eddie Adkins, CPA, a partner in the Washington National Tax Office at Grant Thornton, discusses what parts of the ACA might survive the repeal of most of the law.